Simplification of Convertible Debt and Equity Rules
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Complex securities and financial contracts such as redeemable equity instruments, equity-linked or index instruments, and convertible instruments make distinguishing between liabilities and equity on a company’s balance sheet more complex than usual.
In order to assist in determining the difference between liabilities and equity in all circumstances the Financial Accounting Standards Board (FASB) is currently working on a project to enstate policies the clearly define the categories.
Time for Change
The FASB has been working on this project since 1986 when distinguishing liabilities was added to the FASB’s technical agenda. The board has issued various guidelines to help resolve issues that have come to surface with the liability distinction requirements. The need for more guidance still exists, even after the guidance that has been given.
Accounting professionals told the FASB that the current guidance wasn’t working in 2017. The professionals stated that the current guidance is “overly complex, internally inconsistent, path dependent, form based and is a cause for frequent financial statement restatements.”
In 2019 this project became a top focus for the FASB. This year deliberations on the project will focus on two main points:
- Accounting for convertible instruments with embedded conversion features
- Determining whether instruments are indexed to an entity’s own stock
A convertible instrument is an instrument that can be converted into a different security, generally, a bond or preferred stock, often shares of the company’s common stock. For example, emerging and growing companies often use their convertible debt as an alternative financing solution. The convertible debt is basically a loan obtained by a company from venture capital or angel investors in which both parties agree to convert the debt into equity at a set date.
The complications caused by convertible instruments have become a major source of restatements and confusion. In February of 2019, the FASB tentatively voted to:
- Revise certain disclosures for convertible instruments, including adding disclosure objectives for convertible debt and convertible preferred shares
- Centralize the guidance on convertible preferred shares in Accounting Standards Codification (ASC) Topic 505, Equity, and convertible debt in ASC Subtopic 470-20, Debt — Debt with Conversion and other Options
- Improve the diluted earnings-per-share calculation and derivative scope exception
There are currently five different models to account for convertible debt; the board plans to downsize to one or two models. This downsizing would cause convertible debt to be recognized in the balance sheet as a single liability that is measured at amortized cost. The reduction of methods would also remove bifurcation, or separation, of the conversion feature and the debt host. Also, convertible preferred shares would be recognized as a single equity element in the balance sheet.
Convertible instruments are used by many midsize businesses and start-ups to raise cash. It’s easy for management to miss an aspect of an arrangement, and then use the wrong accounting model under the current complex and inconsistent principles. The current rules also cause some businesses to avoid using these financial alternatives because of their complexity.
The FASB is working to simplify its policies surrounding financial reporting requirements. We are following the latest developments. If you have questions about the current policies or the changes ahead, we can help. Contact us at 818-334-8623 or click here, and we will contact you.